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Thursday, February 25, 2010

Obama Foreclosure Ban Will Spark New Credit Freeze

The Obama Administration, through the Treausry Department, is proposing an outright ban on residential foreclosures unless the mortgages are rejected for possible modifications.

This proposed ban, if adopted, will have disastrous unforessen consequences for all bank depositors, creditors and anyone potentially seeking new loans or even wanting to keep existing credit. In short, it can push the nation -- if not the world -- towards a new and deeper credit crunch.

This is how it could happen. Banks unable to foreclose -- without much greater difficulty and longer delays than at present -- will not be inclined to extend new loans. In the meantime, the banks' balance sheets will deteriorate and their cash flows will lessen.

As the value of assets (the mortgages they have the right to collect payments on) decline, unless there is permanent relief from mark to market accounting (another point for debate; I say no), the banks' capital ratios signifying the ratio of liabilities to assets will increase. In short, banks will become overleveraged again (2007 redux). The result will be a new credit crunch as banks must avoid taking on new liabilities (read: loans) in order to stay appropriately leveraged. Real cash flow will decline, causing a real liquidity crunch in addition.

Defaulting homeowners who are not subject to foreclosure or who can now enjoy new delays will have even less reason to pay anything, and other homeowners in distress will be encouraged to follow this new approach using the same calculus. The burden will shift more and more towards borrowers (on all loans) who do pay on time; they will get nothing except a greater burden, in return for shouldering a greater percentage of the responsibility. The economy can thus be pushed into a death spiral.

As an analogy, consider what happens in a co-op building with common charges borne by all owners. The charges reflect the entire co-op's expenses. If and when some unit owners default, the remaining owners end up picking up the tab.

In a new credit death spiral, borrowers in good standing will be burdened extra, some will become distressed themselves under the weight of the free-riding deadbeats, and the cycle will only worsen.

We need to stop thinking that stopping foreclosures and propping up housing prices is benign. We must encourage -- if not facilitate and accelerate -- the number of foreclosures and make the housing market "bleed out" the sickness. Only then will we have a recovery.

 Eric Dixon is a New York lawyer who has been practicing law since graduating from Yale Law School in 1994. Mr. Dixon cautions that this article is not legal advice. Mr. Dixon has handled election law and other matters for over two dozen political clients, and also handles corporate investigations, due diligence and sensitive matters including crisis management.  Mr. Dixon is available for consultation or comment at edixon@NYBusinessCounsel.com and 917-696-2442.

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